The weakness in commodity prices, particularly coal and iron ore, which caused the slowdown of the mining industry, has hit the growth of mining equipment firms. The mining equipment is a $1 trillion market that employs hundreds of thousands of people around the world. But due to the slowdown, the mining companies have laid off thousands of workers and temporarily closed their facilities. The leading mining and construction equipment maker Caterpillar (CAT) alone has cut more than 13,000 jobs. Overall, the sector’s annual capital expenditure for 2013 is expected to fall by 24% to $76 billion.

Meanwhile, increasing competition from Chinese manufacturers, who mainly compete on price, has made things worse. Nearly 50% of the global demand for construction equipment comes from China, where Caterpillar is engaged in a battle for market share against the local rivals. Earlier in October, Caterpillar released its quarterly results that disappointed investors.

Moreover, for the third time this year, the business has reduced its annual guidance. It’s no wonder that the company’s stock is the 15th most shorted stock according Goldman Sachs' Hedge Fund Monitor which analyzes the positions of 783 funds.

Quarterly Results
In its recent quarterly results, Caterpillar reported a fall in both sales and profits. The company failed to meet the market’s expectation. In the third quarter, Caterpillar’s revenues dropped by 18.4% from last year to $13.42 billion while profits fell by a massive 44.3% to $946 million, or $1.45 per share, from $1.7 billion, or $2.54 per share, a year ago. On the other hand, analysts were expecting earnings of $1.66 per share from revenue of $14.35 billion.

Changes in dealer inventories and a significant decline in dealer deliveries to end users, mainly by its biggest segment Resource Industries, caused the big drop in revenues. Sales in this segment dropped by 42.4% in the quarter to $3.0 billion while profits dropped by 63.3% to $409 million. Besides Resource Industries, the two other leading segments; Construction Industries and Power Systems, have reported a relatively lower drop in sales of almost 7%. On the other hand, while Power Systems witnessed a similar drop in profits, the Construction Industries saw a 43% decline in profits.

Similarly, in its previous quarterly results, the mining equipment manufacturer Joy Global (JOY), reported a 36% drop in orders which caused a 4.9% drop in sales to $1.32 billion while adjusted earnings dropped by 9.1% to $1.70 per share. The company believes that it will touch annual revenues of $5 billion but has warned that the market is “unlikely to support annual revenue above $4 billion.” Meanwhile, the second largest maker of construction equipment in the world, Komatsu Ltd. (KMTUF), has lowered its full-year operating profit outlook by more than 32% to $2.07 billion amid weakness in demand.

Cost Cutting
Although Caterpillar has laid off 9% of its workforce and has shut several smaller plants, it is not done yet. It has recently revealed its plans to close the plants in Beckley, Kilgore and Pulaski. As a result, several hundreds of jobs will be eliminated. The company spent nearly $3.4 billion on capital expenditures in 2012. But this year, the capital spending would drop to less than $3 billion.

Bright Spot
About three years ago, Caterpillar’s CEO said that the company is gearing up for aggressive expansion in China. Then in 2012, the company lost nearly $580 million through the ill-fated acquisition of a Chinese company for $700 million.

However, Caterpillar is still quite optimistic about its future in China. In the previous quarter, Caterpillar did manage to increase its market share in China’s excavators market. The business reported a quarterly growth in sales of 30% to $800 million.

Guidance
Caterpillar has lowered its annual guidance. The company now expects to earn $5.50 per share, as opposed to its previous guidance of $6.50 per share, from revenues of $55 billion, down from the previous range of between $56 billion and $58 billion. Sales in Resources Industries could fall by 40%, while Power Systems and Construction Industries would witness a decline of 5%. This would translate into a 16% decline in annual revenues from last year.

However, Caterpillar continues to generate a lot of cash. In the last 12 months, Caterpillar has generated operating cash flow of $9.6 billion and leveraged free cash flow of $4.6 billion. This cash, coupled with a drop in capex and other cost savings initiatives, would ensure that the company will continue to give healthy dividends in these difficult times. At the current price levels, Caterpillar gives a yield of 2.9%

It Comes Down to Power Systems
Overall, the company will continue to operate in a challenging business environment. The Resource Industries segment will remain under pressure through 2014. As pointed out earlier, the Power Systems has been one of the better performing segments which reported a relatively small drop in sales and profits. However, as JP Morgan’s Ann Duignan has rightly pointed out, this segment will also come under pressure from the lower oil prices. For the next year, Caterpillar’s management believes that its top and bottom line would remain flat, as compared to the current year, or could change by +/-5%.

Caterpillar’s stock has been down 5.9% this year when Dow Jones (DIA) has risen by nearly 23%. However, Bank of America thinks that the stock is a buy with a price target of $100, which shows an 18% upside from the current price level.

While it is clear that Resource Industries will witness further drops in the coming year, but Bank of America is betting on the ability of the company’s Power Systems segment. The firm believes that Power Systems will contribute 50% to Caterpillar’s bottom line and will offset the decline coming from Resource Industries.

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